Can mutual fund managers pick stocks? Clearly, scholars have not been coming to an agreement when it comes to the ability of portfolio managers to earn abnormal returns (Grindblatt et al, 1989). Even more controversial is the question whether those unusual returns are the effect of superior stock-picking skills or just extraordinary luck. Kosowski et al (2006) in their journal article shed a new light on this problematic issue and suggest that in fact we can observe evidence of managerial skills even though it is only visible in a small group of mutual funds. In the following essay I will attempt to argue that the aforementioned article is an interesting, thorough piece of research. Yet, the material which seems to give us an intuitive impression of guaranteed success for skilled managers is, in fact, contrasting many previous researches in the field. This argument will be further developed throughout this critical review, discussing in turn the literature, methodology and concepts. Brief Summary As stated above Kosowski et al (2006) 1 investigate whether in practice mutual funds' excess performance is dependent on luck or extraordinary skills of its managers. Having recognized the persistence in the literature to measure performance controlling for luck, hence eliminating possibility that luck can also continue, they have decided to conduct a thorough examination of mutual fund performance without imposing an ex-ante distribution. In other words their research question assumed that mutual fund alphas do deviate significantly from normality, then asked how many funds would we expect to exhibit high alphas due to luck alone, to finally compare the estimates with actual data in the sample.
Figure 1. showing Number of Funds from the Original and Bootstrap Sample with Performance Above A Certain Value and Cumulative Economic Value (Source: Kosowski et al, 2006).
1 regarded to as the Authors throughout this critical review
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In order to arrive at the findings they examined the performance of U.S. domestic equity mutual fund industry between 1975 - 2002 - which is, in fact, the biggest sample of funds ever researched, very valuable for statistical purposes. The study utilized a bootstrap statistical technique to deal with non-normal distribution of mutual fund alphas, which are a result of heterogeneous risk-taking. The research findings suggest that 9 funds were expected to exhibit an abnormal alpha above 10% per year compared to 29 funds observed within the sample as presented in Figure 1. This result was a solid ground for them to statistically prove that in no way are the abnormal returns a result of luck alone. The findings are beneficial for the investors as they are now better informed with regards to the best source of the biggest utility gain (active versus index funds) and it increases investors trust into well performing mutual funds especially in the times of economic downfall (Kaushik et al, 2013). Hence, the research question is useful in finding validity of the efficiency market hypothesis in mutual fund industry and whether in fact Samuelson (1989) was wrong believing that there are no strategies that would assure abnormal returns in the securities markets. Weaknesses However, was the authors' assumption of persistence in alphas deviation justified? For years casual evidence was supporting the efficiency market hypothesis suggesting that active funds cannot provide higher returns than passive funds and there are no strategies that would guarantee high returns (Jensen, 1968, Samuelson, 1989). Then Malkiel (1995) by using risk adjusted rate of return, which was a great improvement in the accuracy of the calculation, asked whether the funds that did well in one period, continued to earn high returns in the following one. He discovered only weak evidence that funds with better past performance do better than funds with worse past performance. In fact, two years later Carhart (1997) seemed to push the point further and concluded that persistence in excess returns is very weak to non-existent and that much of this persistence results due to expenses and transactions costs rather than gross investment returns - what Kosowski et al do reveal in their article. Surprisingly, they consider this minor persistence a sufficient basis for their assumption of definite abnormal returns for some managers. It seems that this inconclusive relationship between high returns in subsequent periods for the minority of manager are not strong enough to be taken for granted even though such stock-picking stars as Peter Lynch and Warren Buffett exist. Contributions to Literature Nevertheless, the Authors' approach is still an innovative one. Clearly, being critical of the established literature, which has only investigated the persistence of outcomes controlling for luck, they modeled the role of luck in funds performance instead. Kosowski et al made here a very interesting observation, namely that those models discount the possibility that luck can also be a continuing factor.
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Additionally, they have made another contribution to the field of finance somewhat contrasting the findings of Berk and Green (2004), who agreed that skilled mutual fund managers with deviated alphas have decreasing returns to scale in their skills. They believed that profitable managers attract new funds until additional transaction costs decrease the abnormal alphas to zero. In their research they did prove existence of skill being relevant for returns, however shortly. Kosowski et al, on the other hand, claimed that the mean convergence occurs very slowly. Lastly, as mentioned in the summary the authors found strong evidence of superior performance among growth-oriented funds but not with funds having other objectives, which became an inspiration to scholars for further research (Chen et al, 2013). Methodology The methodology used seem to be yet another contribution to the field of finance. The authors reconstructed Carhart's (1997) test of persistence through bootstrapping, checking whether the estimated four factor alphas of star mutual fund managers are a result of luck or to some extent due to skill. The bootstrap technique is commonly used to ensure proper inference and had not been used in that context before. It is important to note here that for proper inferences to be present the following three assumptions must hold: no estimation error, funds having similar risk and individual funds to exhibit normally distributed returns. Kosowski et al noticed, however, that some of those assumptions might not hold for mutual funds. As seen in Figure 2. the estimated results present non-normal cross-sectional distribution. With several bootstrapping techniques applied to monthly net returns, the authors assigned proper measures of accuracy to alpha estimates therefore improving the inference in identifying funds with significant skills (Angelidis et al, 2012). Through applying bootstrap analysis they controlled for the expected idiosyncratic outcomes variation as presented by thinner tails in Figure 2. In the end by reconstructing Carhart's methods Kosowski et al arrived at quite different conclusions. Figure 2. presenting estimated versus bootstrapped cross section of alpha t-statistics (Source: Kosowski et al, 2006)
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Developments in literature since Undoubtedly, the article has introduced new methods and new hypothesis about mutual fund performance. However, has it inspired scholars to further research? In fact, it did. Following its publication Cuthbertson et al (2008) have released a paper on UK mutual fund performance. Applying the same bootstrapping technique into the UK mutual fund industry, they arrived at similar results, namely that poorly performing funds have low returns due to "bad skill". However, it seems that Kosowski's article has initiated a wave of more in depth questions as well. Within the next 7 years a number of scholars have started posing questions regarding the nature of the skills that managers possess, in particular, on style- timing ability. Chen et al (2013) present findings showing that growth timing explains at least 45% of the excess returns reported in the sample. Budiono (2009) on the other hand investigated, using bootstrap methodology, all three timing skills: market, size and growth to discover that style timers do exist and using them minimizes estimation errors. Cuthbertson (2012) elaborates on the skill performance by empirically showing that skilled funds tend to be concentrated on the very right tail whereas the unskilled funds tend to be distributed throughout the whole left tail of performance distribution. Additionally, he builds on the idea of False Discovery Rate and points out that Kosowski's approach could be improved by adjusting for false discoveries. Barras (2010) is yet another scholar to develop the FDR, as well as estimating the proportion of skilled, unskilled and zero alpha funds in the entire population. Conclusions To conclude, Kosowski et al has attempted to answer the question "Can Mutual Fund Stars Really Pick Stocks" and it appears to be a worthy endeavor. I find this article a thorough piece of research that any finance-enthusiast should be inclined to read, mostly for its innovative use of bootstrap technique that uncovered contrasting results to the established literature. Simply through reconstructing the method of Carhart (1997) Kosowski et al arrived at an entirely different conclusion, seemingly more precise. In that way the article is a source of a wave of change in the portfolio performance evaluation. In spite of not being convincing when it comes to justification of underlying assumptions I still believe that through careful statistical analysis the article presents valid conclusions that abolish to a certain extent the efficient market hypothesis. Mutual fund stars can really pick stocks.
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Bibliography Angelidis, T., Giamouridis, D and Tessaromatis, N. (2012) "Revisiting Mutual Fund Performance Evaluation", MPRA Paper No. 36644 Barras, L., Scaillet, O. and Wermers, R. (2010) "False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas", The Journal of Finance 65, pp.179- 216 Berk, J. and Green, R. (2004) "Mutual Fund Flows and Peformance in Rational Markets", Journal of Political Economy 112, pp.1269-95 Budiono, D. and Martens, M. (2009) "Mutual Fund Style Timing Skills and Alpha", Working paper, available at SSRN: http://ssrn.com/abstract= 1341740, 13.11.2013 Carhart, M. (1997) "On Persistance in Mutual Fund Performance", Journal of Finance 52, pp.57-82 Chen, L., Adams, A. and Taffler, R. (2013) "What style-timing skills do mutual fund "stars" possess", Journal of Empirical Finance 21, pp.156-173 Cuthbertson, K and Nitzsche, D. (2012) "False Discoveries in UK Mutual Fund Performance", European Financial Management, Vol.18, No.3, pp.444-463 Cuthbertson, K., Nitzsche, D. and O'Suillivan, N. (2008) "UK mutual fund performance: Skill or Luck?", Journal of Empirical Finance 15, pp. 613-634 Grinblatt, M., and Titman, S. (1989) Mutual Fund Performance: An Analysis of Quarterly Portfolio Holdings. Journal of Business 62, pp. 393-416. Jensen, M. (1968) "The Performance of Mutual Funds in the Period 1945-1964", Journal of Finance 23, pp.389-416 Kaushik, A. (2013) "Performance and Persistence of Performance of Actively Managed U.S. Funds that Invest in International Equity", The Journal of Investing 22, pp. 55-63 Kosowski, R., Timmermann, A., Wermers, R. and White, H. (2006) "Can Mutual Fund "Stars" Really Pick Stocks? New Evidence from a Bootstrap Analysis", The Journal of Finance 61, pp. 2551-2595 Malkiel, B (1995) "Returns from Investing in Equity Mutual Funds 1971-1991", Journal of Finance 50, pp. 549-72 Samuelson, P. (1989) "The Judgement of Economic Science on Rational Portfolio Management", Journal of Portfolio Management 16, pp. 4-12
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